lecture 10 monopoly power and pricing strategiesflash.lakeheadu.ca/~kyu/b5017/b10.pdf · kam yu...

Lecture 10 Monopoly Power and Pricing StrategiesBusiness 5017 Managerial Economics

Kam Yu

Fall 2013

Outline

1 Origins of Monopoly

2 Monopolistic Behaviours

3 Limits of Monopoly Power

4 Price Discrimination

5 Application of Monopoly Theory

6 Total Cost of Monopoly

7 Pricing Strategies of Firms

Kam Yu (LU) Lecture 10 Monopoly Power and Pricing Strategies Fall 2013 2 / 33

Origins of Monopoly

Why is There Only One Seller?

Ownership of a rare resource (diamond, rare earth, mountain gorilla,etc.)

Intellectual property rights — trade marks, patents, copyrights

Exclusive franchise — one cable or phone company in a city

Branding — Rolex watches, Prada, LV

Trade secret — Unique recipe, advanced technology

Network effect — keyboard design, computer operating systems

High fixed cost — economies of scale


Monopolistic Behaviours

Profits Maximization

The monopoly faces the market demand curve. Therefore it is a pricesearcher looking for the price-quantity combination that maximizeseconomic profit.

The necessary condition is still marginal cost equals to marginalrevenue, MC = MR.

For a monopolist, marginal revenue is not equal to market price.

Our assumption is that the firm has to charge the same price to allcustomers.

Therefore if it want to sell one more unit of the product, it has toreduce the price for all customers.

Consequently the marginal revenue declines more rapidly than thedemand curve.



Marginal Revenue of a Monopolist



The Marginal Revenue Curve

The demand function can be expressed as P = D(Q).

Revenue is R = PQ = D(Q)Q.

Marginal revenue is

MR =dR

dQ=

d(PQ)

dQ=

d(D(Q)Q)

dQ= D ′(Q)Q + P.

If the demand curve is a straight line, P = a− bQ.

Then marginal revenue is

MR = a− 2bQ.

Geometrically, The MR curve has the same intercept as the demandcurve but twice the slope.



Demand and Marginal Revenue



Output and Pricing Decision

With an upward sloping MC curve, the monopolist maximizes profitby producing at the output level Q2, where MC intersects MR.

The firm will charge a price that the consumers are willing to pay atQ2.

This means the price P1 on the demand curve (point a).

You should convince yourself that it does not make sense for themonopolist to produce at any other output level such as Q1 or Q3.

At the price-quantity combination (P1,Q2), the monopolies is makingeconomic profit.

But barriers to entry keeps the firm safe from competition.



Comparative Inefficiency of Monopoly

Recall that in a perfectly competitive market, the firms produce atthe level that the market supply curve intersects the market demandcurve.

The supply curve is the sum of all the firms’ MC curves.

For a monopolist, it is where the MC curve meets the demand curve(point b).

At point b, with output level Qc , social marginal benefit is equal tosocial marginal cost, and is by definition economic efficient.

But the monopolist maximizes profit by choosing the combination(Pm,Qm).

At Qm, social welfare is not maximized. There is a “dead weight loss”equal to the area of triangle abc.



Social Welfare Loss of Monopoly



From the Consumers’ Perspective

The output difference between the efficient competitive market and amonopoly is Qc − Qm.

The consumers are willing to pay up to QmabQc for the increase inconsumption.

The monopolist will get additional revenue equal to QmcdQc .

But the cost of the extra output is QmcbQc .

The extra cost incurred by expanding production from Qm to Qc

exceeds the additional revenue acquired by the shaded area cbd.

The net gain to society is the area abc.



Cost-Benefit Analysis of Expanded Production



Profits

In a competitive market the firms can make short-run economicprofits. But in the long run new entries will lower the market priceand make profit zero.

Barriers to entry makes long-run profits possible for a monopolist.

A simple analysis of profit by assuming that technology exhibitsconstant returns to scale. Then MC = AC and are constant.

The monopolist maximizes profit by the price-output combination(Pm,Qm).

Total revenue is the area 0PmaQm, while total cost is 0PccQm.

Monopolist profit is the shaded area PcPmac .



Monopolistic Profits


Limits of Monopoly Power

What a Monopolist Cannot Control

Substitute goods — Mobile phone services instead of the local groundline; sparkling wine instead of champagne; courier services instead ofpostal services.

Competitors reverse engineer trade secret and get around theintellectual property rights problems — Apple computer products,software development.

Deregulation by government — Open sky policy for Canada and theU.S.; NAFTA and other free trade agreements, CRTC’s decision to letcable and phone companies to enter each other’s business.

Antitrust suits against monopoly can be costly. Cases that involveIBM and Microsoft take years to resolve.


Limits of Monopoly Power

Durable Goods Monopoly

Economist Ronald Coase argues that monopolists of durable goodshave no market power.

For example, a land owner can restrict land sales in the short run byraising prices.

But eventually the land owner wants to sell all her land. Rationalbuyers can wait to buy until the price come down on the demandcurve.

The same idea applies to other products such as computer softwareand textbooks.


Price Discrimination

Getting Consumer Surplus

So far we have assumed that a monopolist can charge the same priceto all consumers.

Consumer surplus exists even the monopolist maximizes profit bychoosing (Pm,Qm).

Price discrimination is a pricing structure designed by the monopolistthat tries to capture as much consumer surplus as possible.

The common practices are two-part tariff, nonlinear pricing, andmarket segmentation.

An extreme case that the monopolist extracts all consumer surplus iscalled perfect price discrimination.



Perfect Price Discrimination

This is an extreme theoretical case. The monopolist can sell each unitof its products at a different price.

For each additional unit sold, it charges a price exactly on thedemand curve, which is the consumers’ maximum willingness-to-payat that particular quantity.

Consequently, the marginal revenue is equal to the demand curve.

The firm maximizes profit by setting MC = MR = D.

The monopolist extracts the entire consumer surplus.



Getting All the Consumer Surplus

Note: The MR curve in Figure 10.7 of the textbook is incorrect.



And the Maximum Profits Possible



Two-Part Tariff

The price paid by the consumers involves two parts.

The first part is a fixed fee for the right to buy the product. Thiscomes in various forms such as membership fee, installation charge,connection charge, etc.

The second part is the unit price of the product.

The maximum fixed fee a seller can charge is the consumer surplus ofa customer.

Notice that the higher the market price the lower the consumersurplus.

The extraction of consumer surpluses is imperfect since differentconsumers have difference demand curves.



Nonlinear Pricing

In this case the firm offers different prices to all customers at differentquantities bought by each customer.

For example, each can of soup costs $1.50. But the customers canbuy a box of 12 cans at $12.

The opposite can happen if the item is on sale. A customer can buyup to five cans of soup at $1.20 each. Any quantity over the limit offive will be $2.00 each.

Many products come with different package sizes, each has its ownunit price. Normally the unit price decreases with size (family packs).

The practice is normally used to charge a higher price to smallquantity buyers.



Market Segmentation

Due to imperfect information, a firm cannot possibly identify thedemand curve of each individual customer and implements perfectprice discrimination.

In practice the firm tries to separate different groups of customersaccording to age, gender, location, time, price sensitivity, employmentstatus (student price), etc.

The demand and marginal revenue curves of each market segment isidentified.

The firm sets MC equals to the combined MR.

Price-quantity combination in each market segment is selected bysetting the particular MR to the combined MR.



Imperfect Price Discrimination by Market Segments


Application of Monopoly Theory

Price Control Under Monopoly

If left unregulated, a monopolist chooses a price-quantity combination(Pm,Qm) such that MC = MR.

Government can intervene and set a price ceiling at a lower level, say,P1.

With the price control, the monopolist faces a horizontal MR curve atP1 until it reaches the original market demand curve.

The firm will choose the combination (P1,Q1).

Ideally the government can set the price at the level where MC meetsthe demand curve.



Price Control



Taxing Monopoly Profits

Part of the monopolist’s profits is extracted from the consumersurplus in a competitive market.

The government can in principle impose a tax on a monopolist torecover the surplus.

The tax should be a lump-sum tax which is independent of the outputlevel. This leave the MC curve unchanged after the tax.

In practice, however, the tax is based on accounting profit, noteconomic profit. Then the tax may have an impact on the operationcosts of the firm, shifting the MC curve up. This will result in an evenhigher monopoly price.

Instead of imposing a tax, governments sometimes sell the monopolyrights by public auction. For example, in 2000 the British governmentreceived $34 billion from the bidding of 3G licences of mobile phoneservices.



Price Control



Monopoly Involving Negative Externality

In sectors that involve negative externalities such as pollution, illegalactivities, sex trade, alcoholic abuses, gambling, etc., a monopoly thatrestrict production may be socially desirable.

In Ontario, for example, LCBO exists to control alcohol consumption.

Lotto 6/49 and Super 7 are the exclusive products from the CanadianLottery Corporation.

There are, however, unintended consequences. High illegal drug pricemay result in a higher petty crime rate.


Total Cost of Monopoly

Other Social Costs

Government administration costs of monitoring monopolies.

Wealth redistribution effects — Monopoly profits transfer incomefrom low-income households to high-income entrepreneurs.

The under-production of a key input factor such as electricity canaffect the production decisions of many other sectors of the economy,causing further inefficiency.

The economic profits earned by a monopolist result in less cost-savingincentives in production (higher agency cost, etc.)

Rent seeking — Monopolists have the incentive to spend realresources on influencing government policies. This includes lobbyingactivities, political campaign contributions, bribery, etc. A monopolistcan spend up to the amount of monopoly profit on these activities.


Pricing Strategies of Firms

Profits from Creative Pricing

To implement price discrimination, the key point is to be able to identifyand differentiate the type of customers a firm serves.

Degree of urgency — airline tickets and tour packages are cheaperdepending on the booking time before the travelling.

Degree of patience — Hardcover books are more expansive for readerswho want to get the latest novels as soon as possible. Other readerscan wait for the paperback version. Same applies to movie theatre,DVD, Netflix, and the movie channels on TV.

Fads and fashion — The “latest arrivals” are expansive. Generallystores discount new items after three months, followed by anotherdiscount after six months. Popular sizes will be sold out first, withodd sizes on clearance sales later.



More Creative Pricing

Boxing day sales — demands are more elastic after Christmas thanbefore Christmas.

Coupons — a way to segment price sensitive customers from the lesssensitive one.

Pricing complements — why are the popcorns and drinks moreexpansive than the movie tickets? Movie junkies tend to enjoysnacking more than the casual viewers.

Price discrimination by quality — Manufactures sometimes sell aproduct of less functionality at a higher cost of production. Examples:computer chips that run slower, disabling features in a software,printers that print at a lower speed.

Unadvertised prices — giving customers a discount only when theyask for it.



More Creative Pricing

Meet the competition — a seller pledge to meet or beat the lowestprice in town. This reduces the incentive for the competitors to lowertheir prices, resulting in an overall high average price.

Most favoured customer — low price and rewards to loyal customers.This always reduce the incentive for price competition and results inhigh average price. Examples: different colour schemes for creditcards.

Frequent flyer programs — Practised by many airline companies,basically divide up the market with their loyal customers, resulting inmore market power.


lecture 10 monopoly power and pricing strategiesflash.lakeheadu.ca/~kyu/b5017/b10.pdf · kam yu...

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